One of the casualties of the credit crisis has been the collapse of the auction-rate securities market, an obscure sector of the debt market that was used by municipalities, schools and closed-end mutual funds to raise money. With an estimated $330 billion in outstanding obligations, auction-rate securities (ARSs)essentially are long-term debt instruments that pay short-term rates and that were sold by Wall Street to corporations and wealthy individual investors.
"This was a product that was sold as a cash equivalent," says Barry Silbert, chief executive of New York-based Restricted Stock Partners (RSP), which operates the Restricted Securities Trading Network, an electronic marketplace built for trading illiquid securities. In the wake of failed auctions, the company recently developed a secondary market for ARSs that links investors who want to sell the instruments with hedge funds and institutions that are buying distressed securities.
Before the credit problems erupted, brokers and big banks conducted periodic auctions on a daily, weekly or monthly basis, at which point the interest rates for the ARSs were reset. "If you held these [auction-rate securities], you could decide to get in or out based on the interest rate it was paying," explains Silbert.
In mid-February, however, the auctions started to fail because there was not enough investor demand for the securities that were being sold. Previously, the auctions provided an ample market for investors to buy or sell the ARSs, and the banks would step in and support the auctions by buying whatever excess securities could not be sold. But, "Given the issues with the credit markets, the banks couldn't continue buying these securities and putting them on their balance sheets," relates Silbert.
A Lack of Support
During the week of Feb. 15, 2008, all of the big investment banks — including the likes of Goldman Sachs, Merrill Lynch and UBS — stopped supporting the auctions, according to Silbert. Anywhere between 60 percent and 80 percent of the auctions failed, he contends. As a result, issuers had to pay higher interest rates to compensate for the lack of liquidity, and investors became trapped — they could not sell their securities.
"I've been operating in a vacuum," says Will Randall, a builder in Sebring, Fla., who invested in auction-rate preferred shares, or ARPSs, through his broker at Smith Barney.
ARPSs are high-yield, tax-exempt alternatives to money market funds. Closed-end funds issue preferred shares, which are perpetual, meaning they never mature, according to RSP's Silbert, who says, "The issue with that is it's hard to peg a value on it because you don't know when or if you're ever going to get your money back."
Randall builds homes on speculation; when he sells a house, he says, he puts the cash into auction-rate securities. When the auctions started failing at a high rate in mid-February, Randall had $75,000 invested in three ARPSs. Initially, when the market froze on Feb. 14, according to Randall, his broker said it would unfreeze in two weeks. "Then it became two months," Randall says.
Now the auction-rate market is under investigation because many investors who bought ARPSs were told they could be easily redeemed only to find that there is no way out. In mid-April New York State Attorney General Andrew Cuomo launched a broad investigation into ARSs, sending subpoenas to 18 institutions, the Wall Street Journal reported. Several other states' securities regulators also are investigating ARSs.
The Mother of Invention
While the failure of the auction mechanism has been bad news for investors like Randall, the turmoil created a business opportunity for RSP — which aspires to build the largest marketplace for restricted and other illiquid securities, according to CEO Silbert -- and the company's Restricted Securities Trading Network (RSTN). Launched in September 2005, RSP initially created a telephone-based market with a trading desk for illiquid, unregistered securities consisting of restricted stock, warrants and 144A securities, known as private placements.
Restricted stocks are unregistered securities in public companies that are held by insiders or a person who owns or controls 10 percent or more of the shares. The Depository Trust and Clearing Corp. (DTCC) estimates that there is $1.2 trillion in restricted stock in circulation, according to Silbert.
RSTN had signed up 400 institutions (including hedge funds, banks, mutual funds, venture capital firms and private equity firms) to participate as buyers and sellers -- that is, until the auctions began to fail. Since RSTN began trading ARSs on March 3, 2008, Silber says, the marketplace has nearly doubled its number of participants, to 750. "We're signing up about 40 new users a week now," he relates. "Generally speaking, all of the major banks are participants. And a lot of the public companies are signing up because they hold these securities."
According to Stephen Bruel, senior analyst at TowerGroup, RSP may be on to something. "When you look at Restricted Stock Partners, the business model does make sense," he says. "Restricted securities of that ilk are well used throughout a variety of industries for senior-level compensation. You have hard-to-value securities that are hard to dispose of. What [RSP] did is hit on adding trading venues in those securities."
In fact, Pequot Ventures, the venture arm of hedge fund Pequot Capital Management that is being spun off as FirstMark Capital, believed enough in RSP's business model that it provided RSP with Series A funding in September 2007. According to RSP's Silbert, the firm used the money to speed the launch of a proprietary electronic trading platform for the RSTN. After beta testing the platform last summer, RSP officially rolled out the trading system Jan. 1, 2008, to handle restricted stocks, warrants and 144A securities.
When the auctions stopped in February, however, RSP began to receive calls from ARS holders and the hedge funds that were active participants in RSTN, according to Silbert. "They recognized that a lot of the auction-rate securities were similar to restricted stocks," he says, adding that buyers and sellers of ARSs suggested that RSTN was a perfect marketplace for the instruments. "Not having an active secondary market or near-term maturity, they saw an opportunity to make some money."
According to Larry Lanihan, Pequot Venture's founder and partner, what attracted his firm to invest in the company "was a really bad time coming up in the credit markets." He adds, "Our theory was, if the credit markets go bad, the leveraged buyout deals will end up in unlisted restricted securities that need to be traded."
At the time Pequot invested in RSP, Lanihan adds, he really was thinking about corporate debt from the leveraged buyout deals that would need to be restructured as the economy soured. "There have been a lot of other instruments [that fit RSP's business model] that I frankly never heard of when I made this investment," he concedes, noting that he hadn't heard of auction-rate securities until more recently.
Other Competitors?
Of course, RSP isn't the only firm to recognize an opportunity to facilitate the trading of illiquid, unregistered securities. RSTN is just one of several electronic trading platforms that have emerged to automate trading of such securities. Others include Zealous Trading; Unified Markets; and New York Private Placement Exchange, or NYPPEX. On March 3, Zealous Trading also announced that it will facilitate secondary trading in ARSs, through its Zealous ATS electronic marketplace.
A number of electronic platforms began proliferating in 2007 to automate trading in 144A securities, which also are illiquid and unregistered securities. For example, The Nasdaq Stock Market announced a plan to revamp its Portal Market into an electronic platform to bring more transparency and liquidity to trading of 144A securities. In addition, Goldman Sachs launched the GS Tradable Unregistered Equity system, or GS TRuE, and Bear Stearns and JPMorgan established Best Markets and 144A-Plus, respectively. Further, in August 2007, five Wall Street firms — Citi, Lehman Brothers, Merrill Lynch, Morgan Stanley and The Bank of New York Mellon — unveiled plans to establish Open Platform for Unregistered Securities, or OPUS-5.
Then, last November, rather than duplicate industry efforts and risk fragmenting the 144A market, Nasdaq and 12 investment banks — Bear Stearns, Credit Suisse, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Bank of America, Citi, Deutsche Bank, UBS and Wachovia — agreed to form The Portal Alliance, with a plan to use the Nasdaq Portal Market as their front-end trading system. "At some point, consolidation was going to happen," notes TowerGroup's Bruel. "They all did the same thing with nuances around the edges."
RSTN, however, is not competing with Nasdaq, asserts Pequot's Lanihan. "Our offering is complementary to that of Nasdaq," he says. "Given the amount of services we provide and the type of access and instruments, there are a lot of reasons that people would want to go through our system and not go through Portal in terms of being a full-service processor of these types of transactions," he explains.
Among the services RSTN provides are clearing and settlement, as well as dealing with the brokers and the transfer agents. "It's more than finding a buyer and a seller of the security — it's facilitating the full transaction, from start to end, and that's unique," asserts RSP's Silbert.
"Portal is like a price discovery system for some of these instruments. However, the clearing process for these transactions is very significant, and they're not set up to do that," Pequot's Lanihan contends. "They're set up for shares of Microsoft, and that's a lot different than trading auction-rate securities and a lot different than trading warrant shares in company XYZ. Each one is almost unique in different ways. This lent itself to our strengths as a separate and new offering as opposed to an extension of the markets."
According to RSP's Silbert, complex settlement issues come into play with restricted stocks and warrants, and RSTN already has built the technology to handle this aspect of trading the illiquid instruments. "With the auction-rate securities, there are bidding rights, which are equivalent to ownership rights — it's what entitles the holder to essentially place a buy or sell offer into the auctions. With only two or three brokers participating in an auction, there was never a need for a [formal, automated] process," he explains, noting that the transfer of bidding rights traditionally was a manual process between the buyer's broker and the seller's broker.
"There was never any technology built or process in place to transfer the bidding rights. We're definitely investing time and resources in building the technology to make the transfer of bidding rights more of an efficient process," Silbert adds, noting that RSP is building links to the banks and brokers. "We've been working with a number of the banks to link up our systems."
Back From the Brink
In the meantime, the volume of ARSs on RSTN continues to increase by the week, if not daily, according to Silbert. In April, ARSs comprised about one-third of the volume on the platform, he says. "The auction-rate securities are being sold at a discount to par because the auctions are failing," Silbert notes, explaining that investors who want to get out of the instruments are selling at a discount ranging from 5 percent to 30 percent. Ultimately, Silbert says, if the investment banks don't resume supporting auctions and ARS holders want to sell, a portion of the ARS market is likely to trade in the secondary market forever.
Tired of waiting for information from his broker, Will Randall, the Florida builder, read about RSTN on the Internet and downloaded the platform's online application on a Sunday. RSTN needed to know the Cusip number of the two Blackrock and MSF shares he owned and the name of his broker. He received a call from the network's VP in charge of sales, who wanted to know Randall's expectations.
"I'd like to get 90 percent on the dollar," Randall says he replied, but he added that he'd go as low as 80 percent. A second sales associate called on Tuesday. "What I loved about these guys is that I never got an answering machine or 'I'll call you back,'" relates Randall. "They were super responsive and confirmed e-mails."
Randall, who was sent a 30-page standard purchase agreement and legal document to review, says he was faxed five offers by Tuesday afternoon — the highest of which was 85 cents on the dollar, including a 1 percent commission to RSTN. "Basically, for $11,000, I was out of the [auction-rate securities]," he relates. "I had most of my money, and I didn't have to worry about if I was being lied to."
To complete the transaction, Randall says, he simply had to tell his broker to send the securities to RSTN's escrow account. On Tuesday afternoon, RSTN had the securities in its escrow account, and the next day Randall had the cash from the buyer in his bank account.
